AGB 2020.13 - Fastenal (FAST)
Pretty Good Margins and Returns for a Distributor
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Fastenal
Fastenal is one of the largest distributors of industrial and construction supplies globally and leads in the fastener category. The company mainly distributes its supplies to customers through a collection of branches or storefronts. Roughly 15% of the revenues from these branches come from walk in customers and the remaining 85% is from distribution agreements the company has in place with customers. Fastenal uses the branch locations as last mile distribution hubs for each local market.
Fastenal is known for its fasteners, but the company also sells other industrial products to its end customers. Fasteners are the largest category at 34%, but the company also sells Tools 10%, Safety Products 18%, Janitorial Supplies 8%, etc. Over the past 10 years, Fasteners have declined in terms of mix % by 15%, while Safety Products have increased in mix % by 10%. Fasteners tend to have higher margins due to its low value to weight ratio. This requires leverage of a large distribution model to make decent margins and so there is less competition within this category.
Customers of Fastenal are mostly medium to large industrial corporations. Manufacturing is the largest end market at 42%, followed by Heavy Equipment 26% and Construction 13%. Government/Education and Transportation customers make up a smaller part of Fastenal’s customer base.
The MRO (maintenance, repair and operations) market that Fastenal is a part of is large and fragmented. It’s estimated to be $140B in North America and $380B worldwide, with the largest players commanding between 2%-5% market share. It’s difficult to have product differentiation, but a few companies have seen some success from specialization within one of the sub-categories within MRO (Fastenal with fasteners, MSC Industrial with metalworking). And because of this lack of differentiation, price is a large factor for purchase order decisions and this has impacted many MRO companies’ gross margins over the past 5 years.
At the start of the decade, Fastenal had a LT target of 3,500 branches in North America. The company ended FY19 with over 2,100 branches but has been shrinking its branch locations by 1%-5% annually since FY13, when it peaked at over 2,600 locations. Instead of continuing to grow the company with the branch model, Fastenal pivoted its distribution strategy to be closer to the end customer.
Since FY14, the company has instead chosen to grow through the onsite format. An onsite location is similar to that of a branch location, but it is typically adjacent to or even on a customer’s site. The format is typically smaller and the selection of inventory is customized for that specific customer. Onsite locations have increased at a compounded annual growth rate of 39% from FY14 to FY19 to reach over 1,110 onsites in FY19. The company has identified 15,000 potential onsite locations within Fastenal’s existing customer base.
The company has also increased its vending machine locations by a compounded annual growth rate of 14% during the same time period. Vending machines streamline the supply chain by allowing customers to make last minute purchase decisions in smaller batches. The customers that typically utilize vending are infrequent purchasers and primarily require non-fastener products.
Fastenal has 15 distribution centers in North America (12 in the U.S., 3 outside of the U.S.) and the company sources many of its parts internationally and in particular from China. Fastenal has its own fleet of trucks for its distribution network. The company estimates that the company saves about $100M in costs by operating its own fleet (though initial capital costs are likely not included in this calculation) and it gives the company better control over its distribution. Speed and on-time deliveries are important to moving inventory efficiently and Fastenal tracks delivery times to each of their branch and onsite locations methodically.
For any distribution business margins and inventory turns are important. While Fastenal has historically had one of the highest gross margins within MRO, that has come down from 51.7% in FY13 to 47.2% in FY19. This coincides with Fastenal’s decision to grow through the onsite model and expansion of vending machines. Lately, growth in National Accounts has also had a negative impact to gross margins. However, operating margins have held up better going from 21.4% in FY13 to 19.8% in FY19.
Factors that have and will continue to negatively impact gross margins are:
Higher mix of onsites vs. branches (onsites have lower gross margins as these customers are larger and have more negotiating power)
Higher mix of national accounts (larger customers have more negotiating power)
Higher mix of vending (much lower share of fasteners, which have high gross margins)
This is offset by lower opex from:
Higher mix of onsites (40-50% lower opex vs. branches)
Higher mix of vending (much lower opex vs. branches)
Why is it a good business?
Industrial distribution is not a good business on average because margins are usually thin and there are a limited number of ways to differentiate from the competition. Customer accounts are won (and lost) by the sales team pitching a service that can be bought from many others in the field. Especially since Amazon and other online platforms have started selling industrial parts, transparency around pricing has put pressure on gross margins for the industry.
Fastenal mitigates some of these negative forces by having scale economies and focusing on improving its distribution strategy. Though the MRO market is highly fragmented, Fastenal is one of the largest general industrial distributors after W.W. Grainger. Fastenal leverages its distribution network, company owned fleet and strategic branch/onsite/vending locations to get customers the parts that they need to run their business.
Even though the company has seen its margins compress over the past 6 years, this was mainly a result of an intentional move by the company to combat Amazon’s growth in industrial distribution. Amazon acquired smallparts.com in 2005 and rebranded it to Amazon Supply in 2012. Amazon started by offering 500k SKUs across 14 categories within MRO. Amazon relaunched this effort in 2015 as Amazon Business. Today, Amazon has more than 500k customers that shop on Amazon Business and its prices are lower than many of the large distributors, even those that have focused on building a price competitive online presence.
For example, W.W. Grainger decided that it would compete with Amazon on price and selection, by increasing its SKU count offered and by launching Zoro, an online store for those customers that want a similar experience to Amazon Business. We’ve seen this movie play out before as these types of initiatives get more difficult to maintain over time. Amazon has many more resources to compete in low-returning avenues of growth vs. most competitors.
Fastenal took a different approach. Instead of competing on price or selection, Fastenal decided to get closer to the end customer by increasing the number of onsite and vending locations. The main selling points from Fastenal was that the customer would be able to get the parts it needed almost in a just-in-time fashion and inventory selection would be carefully curated to the customer’s needs. In working with the customer on part selection, Fastenal becomes more than just a vendor but more like a partner.
To achieve this strategy of getting closer to the end customer, Fastenal invested to grow its fleet of trucks and to shrink the average distance from a Fastenal distribution center to a branch or onsite location. Fastenal’s distribution centers are less than the average distance to a branch/onsite location as compared to W.W Grainger or MSC Industrial by a factor of 6x.
From its 12 distribution centers in the U.S. (and 3 outside of the U.S.) Fastenal moves 95% of its inventory on company owned trucks. The company makes 4.3 deliveries per week to each branch/onsite location on average. Fastenal tracks on time delivery statistics weekly and estimates that the average delivery time is before 5am with 86% of the locations getting deliveries by 10am.
And so with this distribution strategy, Fastenal has been able to retain a significant premium to Amazon in terms of price. Because many of the parts that Fastenal supplies are low ticket items, convenience and procurement services can overcome price as a factor in purchase decisions. Goldman estimated that Fastenal products have a 60% premium to the prices found on Amazon, while W.W. Grainger’s online platform, Zoro, only has a 9% premium. W.W. Grainger cut prices the most in 2018, while Fastenal was able to raise prices in FY18 by 0.7%-0.8% and in FY19 by 0.9%-1%.
Returns on capital?
Over the past 10 years, Fastenal has spent 98% of its capital on capex, 6% on acquisitions and sold off PP&E for 4%. Breaking down capex even further, the company has spent 71% on equipment and facilities, 5% for opening supplies, 12% on software, 4% on real estate improvements, and 9% on its fleet of trucks. While it would be nice to estimate on the returns on capital for each of these categories of capital spend, there just isn’t enough information provided to make any reasonable estimate. Furthermore, most of these categories of spend are all related to the investment for growth of the company. Fastenal wouldn’t be able to maintain its growth without investing in new locations, software, real estate and distribution all together.
It would be interesting however to see what the returns look like for a new branch location or onsite. The information here is also a little light to make accurate calculations. However, the company has mentioned that a fully up and running branch location generates between $1.6M-$1.7M per year. That number has increased from $1.25M in FY13 due to the maturation of the newer branches and closures of underperforming branches (or ones that get better economics when the business moved to onsites). The company expects that as branch locations mature, the average revenue per branch would be close to $2.3M. We know that the branches collectively do ~23% operating margins but expect that to move higher as the average revenue per branch goes up. The cost to open a branch hasn’t explicitly been disclosed.
For onsites, the average revenue per year is slightly lower in the $1.4M-$1.5M range. We know that the company has aggressively been growing its onsite locations and thus the average revenue has been declining over the past 4 years. The gross margins for an onsite are lower (Goldman estimates 35% vs. the corporate average of 47%) but the lower opex offsets the gross margin dilution. The operating margin for the onsites collectively are in the upper teens %, but that number should move higher into the low 20%s as the number of onsites become larger and existing onsites mature.
Even with declining gross margins and dilutive operating margins with the growth in onsites, we estimate that the company has generated between 30%-35% returns on its capital over the past 5 years. Just going back to the branch return calculation, if the operating margin is 23% on a $1.65M revenue branch, it would imply that operating income would be $380k per year. If we assume that a branch costs roughly $800k-$900k to open, it would still result in 42%-47% pre-tax return on capital. But that’s just a guess since the cost to open a branch hasn’t been disclosed.
Reinvestment potential?
The MRO market is large and fragmented and so growth is not impeded by lack of opportunity. However, there are structural reasons for that industry dynamic and it would be foolish to bake much higher market share going forward. Fastenal is a best in class operator and it does have the right strategy of growing while moving closer to the end customer.
Fastenal has goals to do over $10B in revenues of which 87% would from the U.S. and Canada. The company is projecting that the fasteners segment will represent close to 25% of revenue, or $2.5B. Fastenal did $1.82B in fastener sales in FY19 and has averaged 8% annual growth in this segment over the past three years. Extrapolating that going forward, Fastenal could reach $2.5B in this segment by FY24. Assuming a lower rate of 5% (the historical 10 year CAGR), Fastenal would reach its target by FY26.
The company expects most of its growth to come from the number onsites, reaching 3,400 when reaching these financial milestones. The company has identified the onsite total addressable market at 15,000 locations. Even with this growth, the company is expecting a similar average revenue per onsite. Fastenal expects that the number of branch locations will remain similar to today but that the average revenue per branch will increase into the low $2Ms.
There are a few concerns around the growth targets set by the company. First is that margins will continue to be pressured by the growth (1) in onsites vs. branches, (2) non-fasteners vs. fasteners, (3) national accounts vs. smaller accounts, (4) vending locations. Second is that international expansion may be more dilutive than the reasons laid out above due to lack of scale and density in the distribution network.
We estimate that Fastenal has returned 30%-35% on its invested capital over the past 5 years and reinvested almost 30% of its capital back into the business. With these high returns, why doesn’t the company reinvest more capital back into the business? The company is over capitalized with only $400M in debt (vs. a 330 in cash and a $28B market cap).
The answer is because this is a B2B distribution company and with growth being primarily driven by onsite locations, signing new customers to allow new onsite locations is the gating factor. A reinvestment rate of 30% isn’t that low when compared to other store/location business models (think Starbucks, Dollar General, Domino’s, etc.), but it’s not as high as aggregator/rollup models like Transdigm and Braodcom. With these assumptions, the company has likely increased intrinsic value between 9%-10% annually during the past 5 years.
What else is important?
Covid impact
Fastenal has been good about providing monthly trends throughout FY20. Starting in Mid-March, product dispenses at its vending machines dipped to as low as 76% vs. the start of the year. That has turned around since late April and crossed over the beginning of the year mark in early September. There is still a difference of where vending is versus where it would be if it were a normal year by roughly 10%.
In terms of customer end markets, there was a similar trend with 2Q being the bottom for Heavy Equipment and Manufacturing. Construction interestingly saw a slight sequential decline in 3Q from 2Q.
On the product category side, fasteners were impacted more than the other products ex-safety products. There was a surge of over 5,400 new customers added from the government and healthcare verticals in 2Q and 3Q, particularly for the safety products. Fastenal estimates that $350M-$360M in surge revenues within safety products were recorded in 2Q and 3Q.
Optionality
The Fastenal business is pretty straight forward. While the company could make a meaningful acquisition to gain share within a certain end market vertical or a particular set of customers, we don’t think that the returns on that investment would be better than if Fastenal invested to grow into those segments directly.
International growth is likely the most obvious call option for the company. Fastenal can take its expertise and processes to tackle industrial distribution in Europe, South America or Asia, but it would require a significant amount of capital and time to gain traction in those markets and to develop a dense enough distribution network to make the investment worthwhile.
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Great article again!